Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, 1957 & Co. (Hospitality) Limited (HKG:8495) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is 1957 (Hospitality)'s Debt?
As you can see below, at the end of June 2021, 1957 (Hospitality) had HK$101.8m of debt, up from HK$20.2m a year ago. Click the image for more detail. On the flip side, it has HK$79.5m in cash leading to net debt of about HK$22.3m.
How Strong Is 1957 (Hospitality)'s Balance Sheet?
According to the last reported balance sheet, 1957 (Hospitality) had liabilities of HK$113.9m due within 12 months, and liabilities of HK$31.3m due beyond 12 months. On the other hand, it had cash of HK$79.5m and HK$8.46m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$57.2m.
While this might seem like a lot, it is not so bad since 1957 (Hospitality) has a market capitalization of HK$115.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While 1957 (Hospitality)'s low debt to EBITDA ratio of 0.61 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that 1957 (Hospitality) improved its EBIT from a last year's loss to a positive HK$12m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since 1957 (Hospitality) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, 1957 (Hospitality) actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
On our analysis 1957 (Hospitality)'s conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Considering this range of data points, we think 1957 (Hospitality) is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with 1957 (Hospitality) , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.